My stab at understanding the economic crisis

Researchers cited in

” Results suggest that prior to early 2004, economic fundamentals provide the primary explanation for house price dynamics. Subprime credit activity does not seem to have had much impact on subsequent house price returns at any time during the observation period, although there is strong evidence of a price-boosting effect by investor loans. However, we do find strong evidence that a credit regime shift took place in late 2003, as the GSE’s were displaced in the market by private issuers of new mortgage products. Market fundamentals became insignificant in affecting house price returns, and the price-momentum conditions characteristic of a “bubble” were created. Thus, rather than causing the run-up in house prices, the subprime market may well have been a joint product, along with house price increases, (i.e., the “tail“) of the changing institutional, political, and regulatory environment characteristic of the period after late 2003 (the “dog”). ”

By the way, GSE stands for government sponsored enterprise – like Fannie Mae backed banks  (I think) 

Ok, so lets take a look at that environment (the dog). Warren Buffet weighed in as noted by this blogger

“In 2003, Warren Buffett called derivatives (such as swaptions) weapons of mass financial destruction. Like everyone else, I have long admired Buffett, but I though he got this one wrong. Derivatives allowed institutions to hedge and therefore reduce risk! Or at least, I thought this was the purpose of derivatives.

But of course, investors can also use derivatives to speculate, and when they do so (and particularly when they do so using leverage), derivatives become very dangerous. AIG, for instance, guaranteed against mortgage default. This meant that when defaults rose to levels not seen since the Great Depression, it didn’t have enough capital to meet its responsibility to its counterparties. So the counterparties who thought they had hedged their risk found themselves exposed, which in turn ate into their capital position, and so a cascade was on.”

What the hell is a derivative? Good old wikepedia:

“Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options, and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs. Unregulated Credit derivatives have become an increasingly large part of the derivative market.”

So here is a relevant question from a comment from the real estate blog?  

“given the huge volume of swaptions done by the GSEs, shouldn’t they have been using their lobbying clout to get them exchange traded and regulated, to reduce this counterparty risk? I understand why Wall St. lobbied against this, but why didn’t the GSEs lobby for it?”

Maybe this will begin to answer the question – from Wikipedia again:

“Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. (The incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.)”

So are economic experts, including academics,  partly to blame for not warning us laypeople loud and often enough? I can understand politicians being quiet, as well financial professionals, as they are frequently known to be corrupted by self-interest. But academics and experts?  Interesting angle.


One Response to “My stab at understanding the economic crisis”

  1. Reena Says:

    Why don’t we switch for a while. You can come be an economist at my job and I’ll be a social worker at yours?



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