They Called him Mr. Doom until Doomsday Happened. My Review of Roubini’s Lessons on Crisis Economics – Part 1

If you’re a soccer fan, how would you feel if you had to miss watching the world cup final and watch it on replay the next day? This is sort of the feeling I have now that I am trying to dig into the causes and consequences of the Global Financial Crisis (GFC): I regret not having been able to understand anything when it was unravelling. To some extent, I found out I was not the only one. Henry Paulson, Secretary of the US Treasury, declared in May 2008 that ‘The Worst is Behind Us.’ Four Years Later, People are not even sure if this statement could hold true now. Learning in hindsight might not have been such a bad thing in the end, since it looks like in 2008, not many people understood what was happening anyways.

One man knew it though. He was not the only one, but he might be the one whose forecasts were the closest to reality. In the first chapter of his books, he calls it a White Swan, a clear contradiction with Nassim Taleb’s opinion of the crisis as being an unpredictable and extremely rare event. Initially, I wanted to write a plain “Global Financial Crisis for Dummies” sort of article, until I read Roubini’s book.

My objective out of this review, is to explain in simple terms the causes and consequences of the global financial crisis, taking as a base the framework Roubini has set up. Economists certainly disagree on a lot of things, but there seems to be some consensus around the causes of the GFC, and Roubini’s framework for laying these causes is simple and straightforward.  At the expense of my writings being redundant with a basic search on Wikipedia, I find that the excess of literature about the crisis has made it even more difficult for average Tony to understand what it is all about, and therefore I will try to simplify things as much as possible. If you’re average Tony, and you’re willing to spend the next 10 minutes of your time reading something that might be useful, then you might want to continue reading.

The White Swan

A good friend of mine once told me while talking about financial crises: ‘the reasons are more or less the same, the tools are different.’ As a matter of simplification, most crises start with a combination of easy credit and herd behavior effect: a group of people agree that a certain asset has suddenly become more valuable. They invest in it (or borrow to do so), thinking that the asset’s price is only going to go up. The movement gains momentum thanks to easy credit or deregulation or both, and you end up with home prices that are multiples of their historical averages. As prices shoot upward, optimists try to explain the phenomena: ‘this time is different’; ‘price are going to stabilize at a higher level’; ‘the rules of the past do not apply anymore’ and all sort of other blabla. Investors (speculators?) get tempted by the story of the guy next door who bought the stock of that tech start-up and sold it for twice the price 2 days later, and they want to put their money too. This is called a bubble.

Now at some point, the herd realizes it is running to a cliff. This is about the time when the asset has been overbought and demand for it slows down. Prices start going down, and investors who realize that the trend has inverted all of a sudden want to sell that asset they hold. Take the example of Average Joe. He heard the rumours and followed the trend: he took a loan for $1M to buy his house which he hopes to sell for double the price in one year. In order to get the $1m loan, Joe had to invest $200K upfront, the rest he got from the bank next door. Unfortunately for him, Joe made this investment at the peak of the asset’s price, and instead of going up, the price of the home goes down. Within 2 month, the price of Joe’s home is now worth $500K. Joe does the math: he has to pay $800K more on his loan, to get in the end an asset that’s worth $500K. Joe decides to default, and gives up the initial $200K. With this decision, he would have lost $200K, but that leaves him better off than losing $500K (initial home price minus current home price).

Joe’s investment and default decision has created a hole in the bank’s balance sheet. Once Joe has defaulted, the bank took ownership of the house ($500k) and had Joe’s initial $200k. All this sums up to $700k, which leaves it $300k short of the loan to made to Joe. Money has disappeared from the system, and this is called credit destruction.

An isolated event such as this one would not in normal conditions have more effect that the a stroke of the wings of a butterfly, but when magnified with inconsiderate leverage (borrowing), deregulation, shadow banking, moral hazard, easy credit and incorrect models for risk estimation, it can turn into a hurricane.

The Models

In order to understand the reasons of the crisis and the policy response advocated, it is important to go through an introduction of the prevailing Economics schools and lines of thought. When they speak about crisis, some economists will tell you that they can partially be due to government meddling too much in the free markets, while others will tell you the reason is governments did not meddle enough. As a simplification, some trust that the markets will automatically correct themselves after disruption, and others believe that markets if left alone can go nuts. These are two fundamentally different schools which advocate different policies for central banks and governments in good times and bad times, but what the US government policy in response to crisis has been so far is to borrow from the laissez-faire school in good times and from the interventionist school in bad times: trust the markets until they go nuts, privatize the profits and nationalize the losses.

Plate Tectonics

Financial Innovation

In itself, financial innovation is a good thing as long as it serves its main purpose: provide liquidities to those who otherwise would not have access to them, and transfer the risk from those who want to hold it to those who do not want to, at a fair cost. If you are a corn farmer in say Brazil and you want certainty in the price of corn which you are going to collect next year, you don’t have to wait until next year to sell it. You can sell a corn Future, which is a contract for the buyer to purchase corn from the seller at a specified date in the future. This way, the corn farmer has transferred the risk of price uncertainty of corn in one year to somebody who wishes to hold this risk, for a premium.

Unfortunately, whether the deeds are good or not, financial innovation has not only brought sound financial products to the markets for the benefit of all, but it has also brought with itself toxic products which can blow in the face of their buyer and seller: the likes of CDO’s and CDS which I will attempt to describe.

Collateralized Debt Obligations (CDO) are probably one of the most toxic product that was ever invented in Wall Street’s laboratories. Imagine Bank Nextdoor which makes mortgages for people to buy house in a certain area. Once a bank makes a loan, it has short term liability (it has to provide the money straight away), but long term assets (it will only get this money back progressively from the lender). In order to avoid this situation, banks found a way to get returns on their loans much faster: bundle them and sell them. They went to investment banks, and gave them a portfolio of loans, which in turn the investment banks bundled with other loans from other banks, and sold them to investors at the other end of the planet, in products they called CDO’s. Practically, Mr. Wang who bought this product in china, has a fixed yearly return of say 10% on, and in the meantime, the money Mr. Wang put in to purchase the product has paid back the loan to the bank. The bank then finds itself in a very comfortable situation: it can lend money to whoever they want, sell it back to Mr. Wang at the other end of the planet and make a flat profit. It does not need to check the credit worthiness of the borrower as much as if it was going to hold the loan by itself. In comes the NINJA loans: No Income, No Job and no Assets!

Now all this works perfectly until the price of the house goes down. Remember Average Joe in the first part of the essay? Now Average Joe has decided to default, but the bank still has to pay money to Mr. Wang. Oops.

To be Continued

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One Response to They Called him Mr. Doom until Doomsday Happened. My Review of Roubini’s Lessons on Crisis Economics – Part 1

  1. Manu says:

    I still believe CDOs are good products, improving the debt quality. What made them toxic is the regulation lack (no independent authority, risk assessment) to control the over-speculation.

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