Friday, February 3, 2012

What Bubble?

FLG found this interview with Eugene Fama very fascinating. He claims there wasn't a housing bubble, but rather the recession caused the housing price collapse. FLG feels Fama is wrong, but cannot figure out how he is. He's obviously right that net leverage always equals zero, but in our global markets that means worldwide net leverage is zero, not that leverage isn't a problem in particular markets or in particular institutions. But for that to be true there has to be some relaxation of market efficiency assumptions, for example, some sort of information asymmetry between American banks issuing mortgage-backed securities and the foreign banks and investors who were buying them.

Guest: Well, they just look at pieces of the data and the fact that the housing market collapsed is taken to be the cause; but the housing market could collapse for other reasons. People don't just decide that prices aren't high any more. They have to look at supply and demand somewhere in the background.

Russ: We did have people holding second and third homes who didn't have the income and capability of repaying the first one.

Guest: Sure. Standards were relaxed. But then you have to look on the supply side, the lending side. The people who were lending to these people had the information.

Russ: Yes, they knew it. I don't think that they were fooled. They were not overly optimistic about the value of those loans. They were willing to do that because they could sell them.

Guest: The puzzle is why they were able to sell them.

Russ: Correct. Now my claim is the people who bought them did it with largely borrowed money.

Guest: No, that's not true. These were bought by people all over the world.

Russ: Correct.

Guest: No one borrowed money. Remember now: savings has to equal lending. For everyone that's short bonds, somebody is on the other side. The net amount of leverage in the world is always zero.

Russ: That's true.

Guest: So you can't tell a story based on leverage.

Russ: So what's your story? I have to think that through. It's undeniably true, and I'm not going to argue with that point. So, what's your explanation of why people bought these things?

Guest: Well, I have no explanation. Again, I'd say the market crashes because of the big recession. Even a minor depression if you like. Remember that all the people buying these subprime mortgages all over the world, they are the ones making the loans in the end, they were sophisticated investors. Institutions, big banks all over the world. They thought these things were appropriately priced. They might have been at that time, but they weren't ex post.


Anonymous said...

"for that to be true there has to be some relaxation of market efficiency assumptions"

"Remember that all the people buying these subprime mortgages all over the world, they are the ones making the loans in the end, they were sophisticated investors"


Financial executive Andrew Butter upon meeting head of Moody's EMEA and the head of the Financial Stability Unit of the Bank of International Settlements:

I asked them both (separately) a question, "don't you think it would be a good idea to do the valuations of the assets properly, like work out how much they will be worth the moment liabilities come due, so you have an idea how much you will be able to get for them at the point of time that you might need to sell them?"

I thought that was a perfectly reasonable question, I mean banking isn't complicated, (1) you lend people money (2) they put up collateral (3) at some point in the future some of the people don't pay the money back, so (3) you sell the collateral, also at some time in the future (4) if the money you get from that is less than what you lent, you go broke.

They both looked at me like I was a lunatic.

Their response if I understood it correctly was (a) it's impossible to predict the future (b) it's much more complicated than that.

Butter's Test Question:
Someone walks into a bank and asks to borrow a trillion dollars; you say, "Great, have we got a deal for you! So what collateral are you offering?" He opens up his bag and reveals that he has a miniature monkey in there, so you ask the person who does the valuations, "How much can I be reasonably sure to sell this miniature monkey for at some unspecified time in the future", and he (or she) says (quite reasonably), "I haven't got a clue".

What would be the most prudent thing to do in those circumstances?

If you said "Oh we will check his credit rating, and we will do a multivariate regression analysis of our database to work out his "score" much if he owns a dog, a bit less if he owns a monkey, so much if he is quarter Hispanic, half White and quarter Cherokee Indian, and so much if one leg is shorter than the other, and then we will assign a standard error to each variable and run a Monte Carlo analysis and work out the probability of default, and if he passes that test we will hand over the money... see... it's complicated!!!"

Well sadly, that's the wrong answer; it's the miniature pet monkey that matters in the end, just focus on the monkey; it's really not complicated.


George Pal

Andrew Stevens said...

There is empirical support for Fama's position. When the "housing bubble" deflated, it also took down home values in places like Denver, Detroit, Cleveland, and Atlanta which had not seen much in the way of appreciation during the "bubble." (Scare quotes on bubble simply because I'm using the word to describe the phenomenon, but not necessarily accepting its connotations.) I.e. the rise in prices was not equitably spread around the country, but the decline in prices has been. I think this is very difficult to explain using the bubble theory, but very easily explained by the recession theory. (There was reason for optimism in the bubble cities until the recession, but no reason for optimism in the non-bubble cities. However, post-recession, there is reason for pessimism everywhere.)

Of course, I'm not saying that this refutes the bubble theory. You can say, for example, that the collapse of the housing bubble in the bubble cities caused the recession which dragged down home values elsewhere. I can think of a number of different ways to study the timing and relative declines in prices which would give us some data to work with and decide which hypothesis best explained the data, but I'm far too lazy to do the work myself for a trivial addition to my knowledge.

FLG said...


Fama also said:
I'm not saying I know. What I'm saying is I can tell the whole story just based on the recession.

He's skeptical that we can actually prove it one way or the other.

I, however, had the exact same thought as you, including the timing and relative decline stuff. And I, as well, am way too lazy.

The Ancient said...

FLG --


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