Nobel winning economist and liberal zeitgeist Paul Krugman suggested today with a straight face that we return to a financial system, as he put it “like the 60s” - pure depository institutions saving and lending with little to no securitization or hedging. He also seemed to half-heartedly pick a fight with Larry Summers. I hope Larry will put down his 17th diet Coke of the day for a moment and take 20 minutes to draft a response for next week’s Financial Times. It would be a debate we would all benefit from. But then again maybe Summers thinks Krugman’s argument is too much of a straw man, too weak and unthreatening to solicit a response.
Krugman’s general sentiment is dead on, in that the financial system of the future cannot replicate the one we’ve just had. But this does not mean we have to roll back all financial innovation in extremus. This doesn’t mean we need to purge Wall Street or banks of anything that is a little complicated. I think more than anything else it means we just need more checks and balances, or in some places the creation of them, like over the counter trading. And it means we need to “keep it simple stupid.” The experiences of the last 6 months are not so much about the creation of new or wildly complicated financial products, as it is a reminder that firms need at least 5% or so cash on hand and need to verify the information their loans are based on (e.g. mortgage applicants). If these two things had been in place we wouldn’t be here today, and Krugman would not have the bully pulpit to adopt his pseudo neo-Ludite financial perspective.
Look at it from the perspective of a newly graduated college student with a decent job, who wants to buy her first house. The ability of this person to get a loan, and the interest charged on it is directly related to the willingness of banks to provide it. A typical bank will have 90% of their portfolio seeking a return in some respect. A good deal of these will be wrapped in recourse debt instruments to provide diversity, and often produce a margin via selling. This diversity represents more risk control for the banks and thus confidence to lend, and this margin represents more money the bank can lend, and thus more favorable credit terms for our post-collegiate house owning aspirant. And the security is only unsustainable, only contributes to a bubble, if the face value is below the current value of the future cash flows – e.g. if significant numbers of those who borrowed the consumer debt that stands behind the security will not actually pay up. This risk can be prevented quite easily with accurate information about the borrowers. This is widely applied today in the government’s new housing plan, which won’t deal with potential borrowers above a 38% debt/income ratio. Of course, to determine this you have to actually record this information. A greasy-haired condo pusher in El Paso wasn’t always accurately reporting this information to banks, surprise surprise! and banks were eager to make the deal anyway to push it up the chain. But this little scheme does not mean securities cannot be properly valued. In fact it just means the Fed needs to require actual records of income to be reported, as they did in February. So, securities can actually be worth more than their market price, and it’s good for the investor who sees a profit, good for the banks who generate more financing, and good for our college grad who can afford a slightly better house on better terms. Krugman would have us, in one radical fell swoop, nix this whole concept. Dangerous idea.
The other part of his argument attacks the big spooky market of derivates, e.g. futures, options and swaps- concepts that have only been around for hundreds of years- from farmers wanting to protect their crops from future unpredictable weather to British spice traders who didn’t want their global deals to be subject to the volatility of foreign exchange currencies. Derivatives just allow risk control, and if you happen to control this risk yourself, an incentive to do so in the form of profit. And yes, rules need to be in place. Like the degree of leveraging and collateral, or who’s trading where- tracking all this is in the works. Yet high finance is not the only place where Lord of the Flies will play out if there aren’t basic rules, and this caveat is no reason to pick on Wall Street. The credit default swaps (you will swap money for my asset if it turns out to totally suck) fiasco with AIG was not a result of the derivatives or futures system, but because they invested in a bubble (quite happily) and didn’t have nearly enough cash on hand to meet their obligations. Options and swaps are banks’ insurance, and without them they will understandably lend a lot less. Which means Krugman’s argument hurts just about everyone who wants to ever use money for anything. We require insurance for a $2,000 Datsun with 270,000 miles, it's the law, why would we not have insurance on $1 billion in mortgage loans? Or 20 million barrels a day of crude that we import? Or pensions? Or… Risk control is paramount and lowers the costs of financing and increases the availability of productivity enhancing capital. Keep it simple stupid.
Krugman’s general sentiment is dead on, in that the financial system of the future cannot replicate the one we’ve just had. But this does not mean we have to roll back all financial innovation in extremus. This doesn’t mean we need to purge Wall Street or banks of anything that is a little complicated. I think more than anything else it means we just need more checks and balances, or in some places the creation of them, like over the counter trading. And it means we need to “keep it simple stupid.” The experiences of the last 6 months are not so much about the creation of new or wildly complicated financial products, as it is a reminder that firms need at least 5% or so cash on hand and need to verify the information their loans are based on (e.g. mortgage applicants). If these two things had been in place we wouldn’t be here today, and Krugman would not have the bully pulpit to adopt his pseudo neo-Ludite financial perspective.
Look at it from the perspective of a newly graduated college student with a decent job, who wants to buy her first house. The ability of this person to get a loan, and the interest charged on it is directly related to the willingness of banks to provide it. A typical bank will have 90% of their portfolio seeking a return in some respect. A good deal of these will be wrapped in recourse debt instruments to provide diversity, and often produce a margin via selling. This diversity represents more risk control for the banks and thus confidence to lend, and this margin represents more money the bank can lend, and thus more favorable credit terms for our post-collegiate house owning aspirant. And the security is only unsustainable, only contributes to a bubble, if the face value is below the current value of the future cash flows – e.g. if significant numbers of those who borrowed the consumer debt that stands behind the security will not actually pay up. This risk can be prevented quite easily with accurate information about the borrowers. This is widely applied today in the government’s new housing plan, which won’t deal with potential borrowers above a 38% debt/income ratio. Of course, to determine this you have to actually record this information. A greasy-haired condo pusher in El Paso wasn’t always accurately reporting this information to banks, surprise surprise! and banks were eager to make the deal anyway to push it up the chain. But this little scheme does not mean securities cannot be properly valued. In fact it just means the Fed needs to require actual records of income to be reported, as they did in February. So, securities can actually be worth more than their market price, and it’s good for the investor who sees a profit, good for the banks who generate more financing, and good for our college grad who can afford a slightly better house on better terms. Krugman would have us, in one radical fell swoop, nix this whole concept. Dangerous idea.
The other part of his argument attacks the big spooky market of derivates, e.g. futures, options and swaps- concepts that have only been around for hundreds of years- from farmers wanting to protect their crops from future unpredictable weather to British spice traders who didn’t want their global deals to be subject to the volatility of foreign exchange currencies. Derivatives just allow risk control, and if you happen to control this risk yourself, an incentive to do so in the form of profit. And yes, rules need to be in place. Like the degree of leveraging and collateral, or who’s trading where- tracking all this is in the works. Yet high finance is not the only place where Lord of the Flies will play out if there aren’t basic rules, and this caveat is no reason to pick on Wall Street. The credit default swaps (you will swap money for my asset if it turns out to totally suck) fiasco with AIG was not a result of the derivatives or futures system, but because they invested in a bubble (quite happily) and didn’t have nearly enough cash on hand to meet their obligations. Options and swaps are banks’ insurance, and without them they will understandably lend a lot less. Which means Krugman’s argument hurts just about everyone who wants to ever use money for anything. We require insurance for a $2,000 Datsun with 270,000 miles, it's the law, why would we not have insurance on $1 billion in mortgage loans? Or 20 million barrels a day of crude that we import? Or pensions? Or… Risk control is paramount and lowers the costs of financing and increases the availability of productivity enhancing capital. Keep it simple stupid.
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