Saving the market will save some others don't like

James DeLong:

Let us stipulate that saving the financial system will indeed have the effect of saving many of the financial institutions and their operators. In the current mood of the nation and the press, this is regarded as a bad thing. Satisfaction will be attained only when every one of these people has been bankrupted, and 6,000 investment bankers crucified along I-95.

This reaction is a bit like protesting against patching the hole in an ocean liner because doing so will save those who made the crucial navigational errors. Watching the navigator sink beneath the waves might be fun, but one's pleasure will be short and gurgly. So let's get real. While some unjustified enrichment is possible, for the most part, if the financial institutions survive and prosper it will not be because they have been "bailed out" but because the system has been saved. So take a deep breath and say "This is good." In the Midwesternism of my youth, "Don't cut off your nose to spite your face."

Another reason for rational restraint is that there are fewer villains in this tale than the news and the political campaigns would lead one to believe. Three basically good things - the securitization of consumer credit, the extension of credit down the economic ladder, and the invention of derivatives - have combined, and the resulting mix turned out to be explosive. Well, live and learn, and do better next time. But first, ensure there is a next time.

For over a year, people have been wrong-footed in their assessments because the fundamental subprime mortgage problem is simply not that large. As of March 2008, S&P estimated writedowns in mortage backed securities of $285 billion, a respectable sum, but not terribly significant in the context of total home mortgages outstanding of $10.6 trillion against home real estate values of $19.7 trillion, the $16 trillion net worth of non-financial corporations, or the massive resources of the financial system. AIG alone, back in the palmy days of 2007, had a market cap of $190 billion and a book value of $95 billion. TIAA/CREF had $446 billion under management. http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf (S&P upped its estimate by $100 billion the other day, indicating its fear of a downward spiral.)

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Three separate things at work, and, while most commentary blends them into one big bundle of confusion, it is worth separating them.

The first element in the crisis is the rise of the asset-backed securities industry. Basically, ASBs are instruments for reducing the risks from mortgages and other credit instruments. Defaults are usually the result of some individual misfortune, such as job loss or health crisis. These are individually uncertain, but statistically predictable. So if enough individual contracts are aggregated, the package becomes reasonably stable. Smoothing out the risks expanded the pool of capital available for home purchases, which is generally thought to be a good thing, if that is how people want to spend their money.

The industry also developed the concept of dividing the payments into tranches. To simplify, a bundle of mortgages can be divided into two sub-bundles, with the first 90% of the payments received going to sub-bundle #1 and the remaining 10% going to sub-bundle #2. Sub-bundle #1 is insulated until the loss reaches 10%, which was regarded as unlikely. (Note, by the way, that in this system the existence of sub-bundle #2 serves the same function as a down-payment in an ordinary mortgage system.) Sub-bundle #1 can then be sold to highly risk averse institutions, which are protected by the double layer of sub-bundle #2 plus ordinary down payments and other credit checks.

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The second element of the crisis was the extension of this system into the subprime market. The basic impulse behind this was not bad. If one accepts the national mania for home ownership (which is highly problematical, but that is another story), then trying to extend it down the economic ladder is a worthy goal. And the creators of the system really thought that by spreading the risks and decreasing the volatility they could indeed make it work.

The mistake was that no one was policing the system....

But this time it truly is different, because the bursting bubble and the subprime mess interacted with the development of the derivatives industry, which is the third component of the explosive mix.

The derivatives industry is new, one of the many children of the information processing revolution, since it would have been unthinkable before the computer. Because of the newness, there is no standardization and no centralized reporting. Buffett's description of it in 2002 was sobering, but mostly because of the opacity. He identified real questions, but there was no way of knowing whether he was describing outliers or the mainstream. If the government and the financial industry were able to analyze the existing contracts and their exposures, the fright factor might diminish markedly.

As with ABSs, derivatives were born primarily out of financiers' desire to limit risk, not to take it. McCain's comment that Wall Street became a casino is true, but not in the sense that he means it - most finance professionals want to be the House, not the player, collecting a steady 1% off a stream of money flowing through. High rollers have their place because they make markets, but they are not the center of the system.

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There is much more in this primer on the pieces of the financial puzzle.

If you read the whole thing it may just make your hair hurt, but you may also have some idea of the complexity that defies simple solutions. You also get an idea of how ridiculous the ornaments are that the Democrats want to hang on the solution to the problem. You may even realize that the glee that the Democrats have in this problem is badly misplaced.

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