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More on the Sub-Prime Meltdown

June 5, 2008

Mickey Kaus responds to my previous post by email saying "I thought the problem wasn’t a bubble, but it was that their fancy computerized hedging programs didn’t work."

I say: Fair point in that my post is probably oversimplified things. The reversal in the run up of housing prices (which in retrospect was a bubble) had several effects:

— First, as I understand it, the collapse of housing prices was at least a major cause of why the hedging programs did not work. The hedging programs were built on statistical models that ceased to work when there were a variety of changes in the market (including falling housing prices).

— Second, the implicit belief that housing prices would continue to rise led to more lenient underwriting standards for sub-prime borrowers on the theory that rising home prices would allow lenders to recover lent funds if individual borrowers were unable to repay their loans. When housing prices began to fall, highly leveraged positions in mortgages (especially sub-prime mortgages) lost a significant chunk of their value.

— Third, high leverage resulted from things having gone so well for so long. This affected the models alluded to in my first point, but more generally infused market participants with the sense that higher leverage really wasn’t as imprudent as it might have seemed previously. That attitude is symptomatic of a bubble.

The high leverage of both (a) individual players in the market and (b) systemically, through the creation of derivatives and the like, resulted in a domino effect of failures of entities/funds that undermined confidence in (i) whole asset classes (e.g. sub-prime loans for which buyers disappeared), and (ii) major financial players like Bear Stearns, who people feared would not honor their obligations with respect to other types of trades and financial transactions (i.e. unrelated to sub-prime loans) if Bear were dragged into insolvency because of Bear’s leveraged positions in sub-prime loans. 

The problem is that these things are only possible to see in retrospect. Prospectively, they are just as easily explained as a "paradigm shift" as a "bubble." Because often they are a paradigm shift. For example are high oil prices today the result of a bubble or a paradigm shift?

Regulators are no better able to answer this question than market participants (probably less able (the insight of public choice economists)), which is what makes effective regulation difficult. At least when one defines "effective" as improving human welfare instead of as something secondary like making sure an institution maintains $X of equity according to GAAP.  

Larry Summers understands this, which is what makes his insights on regulation interesting and helpful.

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