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Monday, February 20, 2012

Progressive fuddy-duddies waxing authoritarian 

Barry Schwartz almost never sounds logical or scientific to me. I'm suprised the New York Times gives him prime space, apart from the fact that he tends to support statist solutions with his non-science. OK, maybe I'm not surprised. At the time they fell in love with him, any argument against privatizing social security, even one as thin and paternalistic as Schwartz, passed uncritically into their pages as received wisdom.

Anyway, his latest suggests that the pursuit of efficiency tends to leave some people in the dust, and we should slow it down with regulations. Despite the word count, that's really all he says.

Given the examples he cites - private equity, subprime mortgages, credit cards and derivatives, I'm astounded he came up with "efficiency" as the problem. How about leverage? Well, perhaps because that would limit the applied scope of his work. Defining the growth of these phenomena as "efficiency" provides an all-purpose argument to slow down..whatever can be cost-justified but Barry Schwartz doesn't like. At heart, Schwartz is a kind of social conservative. Nowhere does Schwartz consider the costs or magnitude of inefficiency (its not good, he says, helpfully). He's writing about economics and has left out deadweight loss, let alone comparing it to any of the theoretical social costs of efficiency. After all, those freed up resources from our mindless pursuit of efficiency just end up invested in additional choices to make us miserable.

Some of Schwartz claims are just wrong. For instance:

bundling mortgages into securities reduces the time-consuming, unproductive friction involved in checking the creditworthiness of each mortgage applicant. You can just let the mortgages of the many work to indemnify the defaults of the few.


No, that was never the purpose of securitization, it was capital relief and leverage. Every originator represented they had done the individual credit work. Diversification simply served to deal with the aspects of creditworthiness that can't be predicted by credit history and loan-to-value. Is there some special feature that makes a large bank-held portfolio of mortgages different from a securitized one? Yes, but it isn't lack of diversification or inefficiency, its better execution caused by retention of risk. Anyway, this howler leads into his primary contention:

..but the financial crisis, along with the activities of the Occupy movement and the criticism being leveled at Mr. Romney, suggests that maybe there can be too much of a good thing. If loans weren’t securitized, bankers might have taken the time to assess the creditworthiness of each applicant. If homeowners had to apply for loans to improve their houses or buy new cars, instead of writing checks against home equity, they might have thought harder before making weighty financial commitments. If people actually had to go into a bank and stand in line to withdraw cash, they might spend a little less and save a little more. If credit card companies weren’t allowed to charge outrageous interest, perhaps not everyone with a pulse would be offered credit cards. And if people had to pay with cash, rather than plastic, they might keep their hands in their pockets just a little bit longer.

Credit cards charge a lot because there are limits to the predictive ability of what they can measure. And if there is "peanut-buttering" of different credit quality, we typically have government price controls to thank for that - they mark some credit techniques and charges off-limits. But more to the point - there are certainly self-help types who prescribe cutting up the credit cards and paying with cash. Well and good. Does this mean the government should step up and restrain people's access to their own assets? That's quite statist and short-sighted. I suspect outlawing ATM access would have some unintended consequences, including *growth* of plastic credit and a black market in cash access at ridiculously high prices.

Finally, does he really believe that the Occupy movement is demonstrating for LESS access to credit? Citations please!

All of this reminds me of Virginia Postrel's excellent discussion of the anti-consumer choice movement for which Schwartz carries the flag. He knows what's good for you and he's going to give it to you good and hard. Don't fall for the laid-back casual contemplative looks and the soft-sounding psychology talk, this is a very old argument for state power.

UPDATE/RESPONSE: "anon attorney" tries to claim I've never heard of low-doc or no-doc loans. I'm afraid I have. I supervise the management of billions of dollars of structured products as well as bank (and other) bonds and I'm quite aware of low-doc, no doc, NINJA and neg-am loans. But their existence is not evidence of Schwarz' point. There are already plenty of regs and disclosures intended to 'slow-down' the issuance proces, such as the 3-day rule in NJ, HUD forms, etc. These loans were designed to extend more credit to more dubious borrowers. "Efficiency" has nothing to do with it, nor, really, does speed. A principal-agent problem is not an "efficiency" problem or an all-purpose excuse to throw sand in our economic gears.

Another commenter says "Still, the credit card companies seem to have *awfully* nice houses because although individual card risk is difficult to measure, when you lump a few million together it gets much easier. "

Again - true, much like making many small bets if the odds are slightly in your favor. The central tendency is likely to win through multiple small bets. But again, this is not somehow unique to securitization or bad securitization. Capital One, BofA and lots of other banks keep substantial credit card receivables on their books. Securitization is driven by the capital requirements and funding costs of retention vs. securitization. I didn't know the credit card companies had houses :).

15 Comments:

By Anonymous Robertgbob, at Mon Feb 20, 11:40:00 AM:

I often feel that the greater availability of credit at all levels of our society has had mixed benefits. For people who can responsibly manage credit it has been a major boon, while for those with poor self-control / planning it has allowed them to get into a lot more trouble. Despite these somewhat paternalistic concerns, I certainly find any proposed statist solution to this problem of greater concern than the problem itself.  

By Anonymous Anonymous, at Mon Feb 20, 12:38:00 PM:

Apparently Andrew H. has never heard of "no doc" mortgages, "low doc" mortgages, or of mortgage fraud, all which became prevalent in the heady days of 2005-2007.

Perhaps relieving the pressure to perform individual credit analyses that was not the purpose of securitization, but it was the entirely predictable (and predicted) end result. In that regard, Schwartz's argument has some validity.

His friction analogue is misplaced, however. Friction is not the reason that automotive engineers can't design a car that gets 100 MPH. It is a simple fact of Newtonian physics that it takes a certain amount of energy to accelerate a given mass to a given velocity. Even at zero drag, 100 mpg is not feasible for an automobile that weighs 3000 pounds.

--Anon Attorney  

By Anonymous Ignoramus, at Mon Feb 20, 02:31:00 PM:

There's several Big Factors in why mortgage securitization went bad.

In the end, on top of everything else, everyone cheated. I'm up to my eyeballs in investigating it, actually. I doubt the public will ever get the full story. "Forget it Jake, it's Chinatown."

We've had a big multiplier effect. The amount of bad mortgages was huge but it could have been fixed for something like $500 billion, with the right plan and the political will to deal with it. We've already spent multiples of that when you add up everything, including shadow support. It wasn't just your basic TARP.

It's all been about bailing out the Big Banks for lots of things.

*****
Friction (if you include air resistance) is the reason why you can't get 100mpg at 100 mph. If you push something in deep space it will continue to move at a constant velocity -- no more energy is needed,  

By Blogger Georgfelis, at Mon Feb 20, 07:15:00 PM:

"Credit cards charge a lot because there are limits to the predictive ability of what they can measure."

Close. Credit card companies charge a lot because they can. They are Unsecured Debt, issued with loose controls, to bad credit risks. Most credit cards that carry a fairly large balance do so for an extended period of time (like ours), with a high (for financial instruments) risk of failure, which in most cases result in no money back for the company. Still, the credit card companies seem to have *awfully* nice houses because although individual card risk is difficult to measure, when you lump a few million together it gets much easier.

Thank God for Dave Ramsey. By the end of this year I will be credit card debt free, which has not happened since I was in college.  

By Anonymous Jr. Dreck, at Mon Feb 20, 07:50:00 PM:

Since we're talking about physics...

The single largest inefficiency in running cars on fuel is the maximal thermal efficiency of the Otto cycle. Even under ideal conditions, the maximum efficiency of an engine is pretty abysmal.

In case you're curious, the maximum theoretical thermal efficiency in an Otto cycle is approximately 1-1/(r^.3), where r is the compression ratio. Under a standard 10:1 compression ratio, this leaves you with 50% thermal efficiency... and this is before you've ever transferred the energy to the wheels.  

By Anonymous Anonymous, at Mon Feb 20, 08:12:00 PM:

Power plants are even worse in thermodynamic efficiency, because the temperature required to get steam to do "work".

And no, an object does not continue at the same velocity if you push it off into "deep space". Gravity is everywhere and prevalent, and will create a drag because with the gravity field and turn any trajectory into an orbit - around "something" with large mass.

Which brings us back to the basic dumbness of economic "friction". Taxes, wages, benefits for employees, trade , competition; all these things cause this so-called economic "friction". This joker with the Times is living proof that there is tremendous economic "friction", as the Times only stays in business because of the weird largesse of Carlos Slim. It is not a profitable organization - something about friction created by high prices for advertizing, operations, and employees. And a product that is not yielding its value in the open market. How much longer will THAT bubble called the New York Times go on before it bursts?  

By Blogger darovas, at Mon Feb 20, 10:44:00 PM:

1) For a given compression ratio, a Diesel cycle is less efficient than an Otto cycle. However, the Diesel cycle allows for larger compression ratios, so practically speaking the efficiency of Diesel engines can be significantly greater than that of gasoline engines.

2) What engineers learn about efficiencies of engine cycles is somewhat of a lie. For example, the Otto cycle efficiency, e = 1 - r^(1-\gamma), where \gamma is the C_p/C_V ratio and r the compression ratio, assumes (i) an ideal gas, and (ii) a quasistatic cycle. The first assumption is not so bad, but the second is usually very poor indeed. A quasistatic process takes an infinite amount of time, since at every step it is assumed to come to thermal equilibrium. So the actual *power* you get out of such a cycle is zero. As shown by Curzon and Ahlborn (Am. J. Phys. 43, 22 (1975)), a more realistic model includes transport effects (i.e thermal conductivities). Under some fairly benign assumptions, the efficiency of a modified Carnot cycle at maximum power output goes as 1 - sqrt(T_1/T_2) rather than 1 - T_1/T_2. This much better approximates observed efficiencies of power plants. On smaller scales, as in an automobile engine, these considerations probably matter less. Next time I teach this subject I'll assign the analysis of the Otto cycle in this regard this as a HW problem.

3) Not all gravitational orbits are bound; orbits with E>0 are unbound. So there is no guarantee that an object moving with a given velocity in "deep space" is necessarily in a bound orbit for some massive object. Escape velocity is sqrt(2GM/r), where M is the mass of a planet/star/galaxy and r the distance from it (here we are assuming M is much larger than the mass of the object itself). And even if it were to be bound, space is of course vast, so it could be moving at what is essentially a constant velocity for quite some time. It is then a matter of time scales.

4) Gravity does not only provide a "drag" -- it can also accelerate objects. This is what lies behind the "gravitational slingshot effect", which has been used by physicists and engineers to design grand tours of the outer planets (e.g. Voyager).

5) Economics is not remotely at the quantitative, predictive level of physics and chemistry. I doubt even most economists would disagree with that. But it seems much worse still for economics - leading scholars argue vigorously over seemingly basic issues: Keynes vs. the Austrians, for example.  

By Anonymous Anonymous, at Tue Feb 21, 12:38:00 AM:

Andrew, I believe it is thoroughly documented and undisputed that mortgage fraud was rampant amongst mortgage originators in the various nontraditional mortgage markets. Further, it is well documented that the securitization industry was fully aware of the widespread fraud and turned a blind eye because they made spectacular profits both on securitizing the mortgages and on selling CDS contracts.

Barry's point seems to be that separating the risk from reward led to market structure in which nobody had proper incentive to check credit.

Are you denying both of these points?  

By Anonymous E Hines, at Tue Feb 21, 10:43:00 AM:

...while for those with poor self-control / planning [greater availability of credit at all levels] has allowed them to get into a lot more trouble.

But the answer to this is not more regulation, but less. Let free market forces do their trick--in this case by allowing the creditor to charge those with empirically demonstrated greater repayment risk higher--risk-based--interest rates, or decline to lend to that person at all.

Eric Hines  

By Blogger Andrew H., aka "Mindles H. Dreck", at Tue Feb 21, 08:19:00 PM:

Anon - I would agree with both your statements if you'd just strike the "Barry's point seems to be" part. What he actually says is -

"And bundling mortgages into securities reduces the time-consuming, unproductive friction involved in checking the creditworthiness of each mortgage applicant. You can just let the mortgages of the many work to indemnify the defaults of the few."

So it's some weird effect of speed and diversification rather than the principal-agent problem that you identify (and that I alluded to in my response to you above).  

By Anonymous Anonymous, at Wed Feb 22, 10:10:00 AM:

Andrew, I read those sentences as a poking reference to the theory propounded by Wall Street banks that pooling of large numbers of high-risk mortgages could magically convert the asset from a high-risk asset to a low-risk asset. Obviously, this theory has been debunked. A competent statistician would have said it was flawed from the start because default risks were not independent.

Eric, we did let market forces do their trick--right up to the point at which the banks became insolvent, whereupon we abandoned free market principles and shelled out trillions of dollars to save these failed institutions.

Something has gone deeply wrong in the Republican party, at least from the perspective of someone who was raised in the age of Reagan. This Party used to be the party of free market economics, low, flat, and fair taxes collected from a broad base, and smaller government. Over the course of the last 20 years the party has morphed into a party which supported a massive bailout of the banking industry, a tax structure littered with indefensible loopholes for special interests, and has become fundamentally unserious about shrinking the size and scope of government.  

By Anonymous E Hines, at Wed Feb 22, 12:07:00 PM:

...we did let market forces do their trick--right up to the point at which the banks became insolvent, whereupon we abandoned free market principles and shelled out trillions of dollars to save these failed institutions.

Only partly. Don't forget that CRA and Left protestors forced the banks to make bad loans to poor credit risks at interest rates that did not reflect those risks. Although I don't have much sympathy for bankers who were too chickens*t to resist the protestors. This set the stage. The bailouts never should have happened. There's no such thing as too big to fail, except in the minds of some politicians.

Something has gone deeply wrong in the Republican party, [usw]

On this we agree. Although I think they're the lesser of the evils that are our options this fall.

Eric Hines  

By Anonymous Ignoramus, at Wed Feb 22, 12:44:00 PM:

“Don't forget that CRA and Left protestors forced the banks to make bad loans to poor credit risks at interest rates that did not reflect those risks.”

That’s only a partial explanation. So partial as to be misleading.

A lot of people got put into too much house, with the lure of low-teaser rates. When someone tells you can “own” for no money down, for less than it costs to “rent”, it can be hard to say no. It wasn’t all “unwashed masses” who did this.

We ignored the most basic rule of mortgage finance: down payments matter. Without equity in the home, the owner is just a renter with an option to buy.

Wall Street turned into a machine that stood to make far more money on a potentially “bad” mortgage it could securitize than on a well-underwritten agency-eligible prime loan, when it came to origination fees, and then later servicing fees. “Bad” really means higher margin. Banks captured a lot of this spread in the process of the securitization.

An important “multiplier” here was the easy grant of AAA-ratings, and investment rules that favored AAA-investments. This was particularly true under the Basel international capital rules for banks. Many banks [and other financials] which didn’t originate MBS, bought them either directly or embedded in yet another structured product. The capital rules put far less risk-weight on AAA, so you could goose nominal ROE. Managers got paid on ROE. Nice work while it lasted. The same effect was true for investing in sovereign debt.

Another aspect of the financial debacle was the over-reliance on models, especially models that ignored the risk of correlation and “fat tails”. When you tie that to over-regulation like the Basel rules – which is just an invitation for the too clever to create adverse fat tails, you have a recipe for disaster.

On a grand scale our federal government is playing the same game as the homeowner with too much house, by putting on lots of debt when rates are low. Long-term it’s a trap. I’m looking at you, Big Ben.

Most of the Congressional Republicans are complicit in this. The Republican Establishment doesn’t want to know from the Tea Party. Mitt’s been their guy. How’s that working out. In a month it’ll be Jeb Bush, which I suspect has been Karl Rove’s plan all along.  

By Anonymous Ignoramus, at Wed Feb 22, 12:44:00 PM:

“Don't forget that CRA and Left protestors forced the banks to make bad loans to poor credit risks at interest rates that did not reflect those risks.”

That’s only a partial explanation. So partial as to be misleading.

A lot of people got put into too much house, with the lure of low-teaser rates. When someone tells you can “own” for no money down, for less than it costs to “rent”, it can be hard to say no. It wasn’t all “unwashed masses” who did this.

We ignored the most basic rule of mortgage finance: down payments matter. Without equity in the home, the owner is just a renter with an option to buy.

Wall Street turned into a machine that stood to make far more money on a potentially “bad” mortgage it could securitize than on a well-underwritten agency-eligible prime loan, when it came to origination fees, and then later servicing fees. “Bad” really means higher margin. Banks captured a lot of this spread in the process of the securitization.

An important “multiplier” here was the easy grant of AAA-ratings, and investment rules that favored AAA-investments. This was particularly true under the Basel international capital rules for banks. Many banks [and other financials] which didn’t originate MBS, bought them either directly or embedded in yet another structured product. The capital rules put far less risk-weight on AAA, so you could goose nominal ROE. Managers got paid on ROE. Nice work while it lasted. The same effect was true for investing in sovereign debt.

Another aspect of the financial debacle was the over-reliance on models, especially models that ignored the risk of correlation and “fat tails”. When you tie that to over-regulation like the Basel rules – which is just an invitation for the too clever to create adverse fat tails, you have a recipe for disaster.

On a grand scale our federal government is playing the same game as the homeowner with too much house, by putting on lots of debt when rates are low. Long-term it’s a trap. I’m looking at you, Big Ben.

Most of the Congressional Republicans are complicit in this. The Republican Establishment doesn’t want to know from the Tea Party. Mitt’s been their guy. How’s that working out. In a month it’ll be Jeb Bush, which I suspect has been Karl Rove’s plan all along.  

By Anonymous Anonymous, at Sat Feb 25, 05:09:00 PM:

I don't know much about securities (the 1st half of Anon Attorney's post), but I do know something about physics (the 2nd half).

Anon Attorney, what is the "gas mileage" to-date of the LAGEOS satellite (which weighs about as much as a small car)? What "gas mileage" will it achieve before it comes to a stop?

(My back-of-the envelope estimates: 3E+05 mpg to date, 7E+10 mpg before stopping. If you're not familiar with scientific notation, that's 70,000,000,000 miles per gallon. Seventy billion.)

Moral #1: Physics advice from lawyers ~ legal advice from physicists

Moral #2: When a non-physicist confidently states that something is "a simple fact of physics," it isn't.

--Anon Physicist  

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